2. Joel Franklin is a portfolio manager responsible for derivatives. Franklin observes an American-style option and a European-style option with the same strike price, expiration, and underlying stock. Franklin believes that the European-style option will have a higher premium than the American-style option.

a. Critique Franklins belief that the European-style option will have a higher premium. Franklin is asked to value a one-year European-style call option for Abaco Ltd. com- mon stock, which last traded at $43.00. He has collected the following information:

Closing stock price Call and put option exercise price One-year put option price One-year Treasury bill rate Time to expiration

$43.00 $45.00 $ 4.00

5.50% One year

b. Calculate, using put-call parity and the information provided, the European-style call option value.

c. State the effect, if any, of each of the following three variables on the value of a call option: (1) an increase in short-term interest rate, (2) an increase in stock price vola- tility, and (3) a decrease in time to option expiration.